What Doesn't Kill Gold Makes It Stronger

I've been emphasizing for months that the current correction in the gold price
is a result of speculative money fleeing the market and not any reflection
of gold's long-term fundamentals. Unfortunately, there is so much money to
be made (and lost) by day trading that my cautions have once again fallen
on deaf ears.

Well, it looks like the so-called "technicals" are starting to support my
theory, and so this month I'm going to depart from my typical discussion
of market fundamentals and take a look at the COMEX gold futures market.
It turns out that the same paper markets that helped drive the price of gold
down are beginning to run into the hard reality of physical gold demand;
their reversal may push gold to new highs.

Reading the Futures

The world of futures contracts is often confusing for ordinary investors.
It is mainly the domain of institutions seeking to hedge and professional
speculators. I do not recommend passive investors get involved in futures
trading, but it is helpful to understand how these financial instruments
affect gold's spot price.

In its most basic form, a gold futures contract is an agreement to buy a set
amount of gold at the current spot price with delivery guaranteed at a future
date. The attractive part is that you don't need to pay the full price up
front. You can put a down payment on 100 ounces of gold today, knowing that
you will only have to complete the payment when the contract comes due. If
the price of gold rises in the intervening time, you've made a nice profit,
because you end up paying today's price for a product that is worth more
in the future. Of course, the person who sold you the contract takes a loss
for the same reason. The person buying the contract is said to be "long" gold,
while the seller is "short."

One of the reasons gold futures are so risky is because of the sheer quantity
of gold that transactions represent. When you buy a single COMEX gold futures
contract, you gain control - and responsibility for - 100 troy ounces of
the yellow metal. So when the gold futures market was said to have made "big
moves" this last April, that was an understatement - on April 12th, it opened
with a sell off of 100 tons of gold!

It gets worse. Traders often leverage (borrow cash) to buy futures contracts,
with the down payment they supply known as the "maintenance margin." The
minimum maintenance margin for a single futures contract is only $8,800.
If spot gold is at $1,300, then a trader can gain control of $130,000 worth
of gold with less than 7% down! Depending on a combination of luck and experience,
this massive leveraging can lead to either amazing profits or devastating
losses.

Let's walk through an example, keeping in mind that my figures are very simplified,
because a futures contract is not exactly equal to 100 times the current
gold spot price. Most of the time, futures prices are a little higher than
spot gold.

Say gold is at $1,300, which means a COMEX gold futures contract gives the
investor control of about $130,000 worth of gold. A trader buys a contract
with only a $8,800 margin. If the price of gold goes up to $1,500, the futures
contract is now worth $150,000. The trader can now sell that contract and
pocket the difference. He just netted about $20,000 with only $8,800 in seed
money. If the trader had simply bought $8,800 worth of physical gold, he
would have only earned about $1,350 in the same time period. It is not hard
to see how futures trading can seem exciting and profitable on its face.

But what if the price of gold goes down in this scenario? The more the price
of gold drops below the contract price of $1,300, the more the investor will
be required to add to his margin to maintain the same ratio of down payment
to loan value. This is required as assurance that he will not abandon the
contract. In the worst case scenario, the trader cannot put up the additional
funds and the entire position is liquidated by his broker.

So far, this example is of a trader "going long" with a futures contract.
It can be risky, but the potential losses of a long futures trader are nothing
compared to the losses someone shorting the market might experience.

Consider the same scenario above, except this time the trader has a short
contract. He is desperately betting that the price of gold will drop enough
for him cover his short position (buy back the contract he sold) at a lower
price. After all, he can not hold the contract to maturity, as he does not
actually own any physical gold, and thus would not be able to deliver to
the buyer.

The key difference between long and short traders is that shorts are forced
to add to margin when the price of gold goes up. Unlike a drop
in the price gold, which can only go so low, there is theoretically no limit
to how high the price of gold can rise. Someone betting on gold's demise
with short futures contracts when gold enters a big bull market can be completely
devastated by their margin calls.

It's risky enough leveraging into a deal as aggressively as futures traders
do, but if traders don't understand the fundamentals of the asset underlying
the contract (in this case, actual physical gold), they can get into a lot
of trouble and in turn distort the price of the commodity they are trading.
This is precisely what is happening now.

The Short Squeeze

When gold began its price drop in April, we saw a rush of paper gold flee
the market, including record-high ETF outflows. Major money managers and
hedge funds began selling their gold positions, issuing lower and lower forecasts
for the year-end gold price. All of this became a major signal for futures
traders to short gold.

The selling feeds on itself as the traders seek to cut their losses, or retain
some of the paper profits the earned on the way up. Sometimes the selling
is fueled by "stop sell orders," which are orders on the books that are automatically
triggered when prices decline to a specific level, in many cases just below
key technical support levels. Stops generally become market sell orders as
they are hit, accelerating the decline and thereby triggering even more stops
as prices fall lower. Some stops represent long positions being covered;
others represent new short positions being established.

This ongoing shorting of gold builds a cycle that feeds on itself. The shorts
see others fleeing the market and so continue to short. Meanwhile, the fund
managers see the net-short positions increasing and so they continue to sell
gold.

This cycle continued right up until gold's rebound - in July, the gold net-short
positions reached record highs.

When gold began to rebound last month, a massive number of shorts were left
exposed and many still remain exposed. Gold shorts are stuck holding the
losing bet on an asset that is going to do the opposite of what they anticipated.

If the price rally continues, these traders will feel increasing pressure
to unwind their shorts before their losses become catastrophic. This "short
squeeze," as it is known in finance, will reverse the vicious cycle and could
send gold dramatically higher than when the correction started.

An Unbalanced Ecosystem

To understand this short squeeze, imagine a brand new predator entering a
pristine natural ecosystem. The newly introduced predator finds a smorgasbord
of prey that have never learned to outrun, outsmart, or avoid this particular
predator. Before long, the predator becomes "invasive" and begins to devastate
the natural population of its easily-captured food source. Thriving on the
newfound resources, the population of the invasive predator surges to new
highs - until the prey population collapses.

This is akin to what has happened with gold shorts in the past three months.
The more the price of gold (the prey) was driven down, the more gold speculators
(invasive species) entered the market to profit from this trend, which only
served to drive the price down further.

However, as in a natural ecosystem, this relationship is unsustainable. Eventually
there are so many predators that they run out of enough prey to share. This
forces the predators to starvation, and eventually the population drops to
a sustainable level while the prey manage to grow back to a natural equilibrium.

The overwhelming problems for the shorts is that the gold they sold on the
way down will not likely be for sale on the way up. My guess is that the
buyers who previously stepped up to the plate were not short-term traders
like the speculators who sold. These were buyers who bought gold to own it,
not to trade it. For these buyers, like foreign central banks, the gold they
bought is not for sale at any price (at least not a price the speculators
can afford to pay). The buyers over the past few months have been lying in
wait for this opportunity for years.

The result of this price decline is that gold has moved from weak hands to
strong. In addition, the weakness in the price of gold has caused gold miners
to shut mines, reduce capital expenditures, and limit exploration/development.
So gold that was once on the market will be gone, and future supply coming
from new production will be diminished. So when the market turns around,
how will the shorts cover? Where will the gold they need to buy come from?
When traders want back into the ETFs, where will the ETFs get the physical
gold they need to buy? How much higher will prices have to rise to bring
that supply back onto the market? I really have no answers to these questions,
but it sure will be fun for the longs, and painful for the shorts, to find
out.

What you and I can really hope for is that this massive short-squeeze becomes
the impetus to focus the market back on gold's fundamentals and begins to
drive the yellow metal back toward its previous highs. If I'm right that
gold is still grossly undervalued, then this might be the beginning of the
biggest rally we've yet seen.

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Peter Schiff is an economist and investment advisor specializing in the foreign
equity, currency, and gold markets. He became internationally known by successfully
forecasting the collapse of the dot-com bubble, the US housing market bubble,
and the bankruptcy of major global banks. Schiff is Chairman of gold bullion
dealer SchiffGold and CEO of stock
brokerage firm Euro Pacific Capital. He
frequently delivers lectures at major economic and investment conferences,
and is quoted often in the print media, including the Wall Street Journal,
New York Times, LA Times, Barron's, BusinessWeek, Time and Fortune. His broadcast
credits include regular guest appearances on CNBC, Fox Business, CNN, MSNBC,
and Fox News Channel, as well as hosting his own weekly radio show, The
Peter Schiff Show. He is also the author of several bestselling books,
including "Crash Proof: How to Profit from the Coming Economic Collapse" released
in 2007 before the financial crisis struck, and the more recent "How An Economy
Grows And Why It Crashes" and "The Real Crash: America's Coming Bankruptcy."